Posted on: January 25, 2016

The financial market gyrations of early 2016 coincided with a decline in the oil price from $37 to only $27, but the two have very different causes and effects. The dropping oil price is just the latest in a long decline that began in late 2014, is caused primarily by global oversupply of oil, and has had and will continue to have significant impacts on nearly all Albertans. In contrast, this year’s decline in global stock prices seems to be mainly a result of negative sentiment rather than negative fundamentals, has had minimal impact on most investors, and will likely prove to be just another bump in the investment road.

Financial markets: sentiment and reality

While global stock markets are down nearly 10 per cent this year, this drop seems to be driven more by negative investor sentiment, along with constant media reinforcement, than by economic or financial fundamentals.

A few examples should help illustrate this.

The first example concerns two measures of US economic activity, retail sales (yellow) and monthly changes in private sector jobs (burgundy). The jobs report was released first and showed an exemplary increase of 275,000 jobs in December, along with upward revisions of 40,000 to the prior two months, but the US stock market shrugged off this good news and declined one per cent.

One week later, the December retail sales figure was released and it declined 0.1 per cent from November, one of at least seventeen declines the same or larger since the US economic recovery began in mid-2009—none of which derailed the long-term upward trend. But investors and the media jumped all over it as sign of an impending US economic slowdown and US stocks dropped two per cent that day (and at one point within the day were down three per cent).

The second example concerns China, which is the world’s largest country by population and, due to extraordinary growth in economic output per person over the last 35 years, is now also the world’s largest economy. (Its output per person is still far below developed-world standards, but is vastly improved over its 1980 levels). China’s economic growth rate slowed in the past few years and is predicted to slow somewhat again in the next few years, which allows nearly all media commentators to breathlessly exhort about “the effect of a slowing China on global economic output.”

Nearly all those commentators forgot that direct economic impact requires a transaction. How much does China, the world’s largest economy, transact or trade with the rest of the world?

The answer is surprisingly little, other than with the countries in its immediate vicinity such as Taiwan, Thailand, South Korea, and Japan. Exports to China represent only one per cent of Canadian and US GDP. The US exports about twice as much to Canada as to China, and Canada exports nearly 25 times as much to the US as to China.

Furthermore, how bad is China’s economic slowdown? In early January the World Bank revised its estimate of China’s 2016 economic growth to 6.7 per cent, down only 0.3 per cent from last June’s estimate of 7.0 per cent. Later in January China’s government confirmed that the 2015 growth rate was 6.9 per cent, down only 0.1 per cent from the expected growth of 7.0 per cent.

Not only does China have very modest trade ties with North America and therefore little direct impact on our economies, but the Chinese economic slowdown seems little more than a rounding error.

In short, investor sentiment is currently very negative and so good news is almost entirely disregarded, while bad news is magnified many fold.

This is not to say that stock market gyrations caused by sentiment cannot create their own fear and be self-sustaining, at least temporarily. They can. And it’s not to say that two stock market dips in less than six months didn’t unnerve many investors. They did.

But we should recall that last August’s stock market dip, one of many during the economic recovery, was completely recovered by October, and we need to see the situation for what it is.

Let’s compare today with late 2008. As of this January 20, US stocks are down about 12 per cent from their peak of last December. But in late November 2008, US stocks were down more than 50 per cent from their October 2007 peak!

The US unemployment rate has dropped to 5 per cent and the US economy is doing so well that the Federal Reserve raised its target interest rate a quarter-percent last December. But by late 2008, despite the Fed’s interest rate cuts of over four per cent, US unemployment had risen nearly two per cent, half the US financial sector had collapsed and the other half was on government-funded life support, and things were about to get much worse as the US entered its worst recession since the Great Depression. 2008’s stock market decline was huge and was all about fundamentals; 2016’s is small and is all about sentiment.

So sit back, go for a walk, and turn off the financial news channel or website. Remember that the media’s objective is get attention by creating hype, not to provide useful financial advice. The occasional bump in the road is part of the ongoing trade off we make in order to benefit from stocks’ higher long-term returns, so don’t turn a temporary market decline into a permanent loss by selling low and then buying high. Instead, stick to your long-term strategy.

Falling oil and the Compass Portfolios

The most difficult question we faced during the Compass Portfolio Series’ 13-year history was why the funds didn’t own far more Canadian and energy company shares. Our answer was very simple: why put all your investment eggs in one basket when it’s so easy and effective to spread them across several baskets?

It’s very difficult to diversify a person’s career path, or to diversify an economy. However, diversification of an investment portfolio is simple and helps avoid the potentially disastrous consequences of a highly concentrated portfolio, whether in technology and telecommunication stocks in 2000-2002, US financial companies in 2008, or the unfolding situation with global energy stocks.

Moreover, a portfolio concentrated in energy companies was even more dangerous for Alberta-based investors, who automatically had a lot of eggs already sitting in the energy basket because of our jobs, our home values, our businesses, etc.

Unfortunately, the oil price is now in the doldrums and so our province faces additional painful adjustments1. However, one bright spot for investors in the Compass portfolios is the muted effect of these oil price declines on portfolio returns. For example, over the last five years even the most aggressive Compass portfolio—Maximum Growth—never had more than 11 per cent of its holdings in energy company stocks.

As a result, Compass Maximum Growth was up nearly seven per cent last year although Canadian energy company stocks fell 23 per cent, and so far this year the portfolio is down only 6.5 per cent while energy stocks are down more than 14 per cent. (The other Compass portfolios’ returns are smaller in magnitude.) Effective diversification generated a lot of skeptical Compass investors when oil was heading up, but a lot of relieved investors when oil turned down.

1Just as we know it’s cold outside when we look upwards 10 degrees just to see minus 30, we also know oil prices are low when we look upwards ten dollars or more just to see $40 per barrel.

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